Thursday, April 23, 2009

Nineteen (or more) principles for financial regulation, #1: Build a Firewall

In all the coverage and discussion of the financial crisis, I've been disappointed by the paucity of ideas about what the financial system should look like at the end of the tunnel. I typed up a double-sided page to hand out at the A New Way Foward rally. That was a complete wash-out: the internet has to be a better way of distributing my thoughts on the subject. So now I have a blog. And with that, here's #1.

Build a firewall.
The financial system exists to serve the real economy by allocating capital, providing information for other real-sector decisions regarding risk and the timing of saving and dis-saving, providing liquidity for current transactions, and facilitating some government interventions in the economy. But it doesn’t always work right. When it fails, nothing great is lost by its failure per se – but much may be lost as a result of its influence on the real economy. When the financial system functions well, its signals that certain firms should be liquidated are invaluable. But if it starts sending those signals wildly, the cost of liquidating valuable real capital can be devastating. Build a firewall that shuts down those signals when something goes badly wrong.

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